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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Digital China Holdings Limited (HKG:861) is currently trading at a trailing P/E of 38.2, which is higher than the industry average of 13.6. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
See our latest analysis for Digital China Holdings
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for 861
Price-Earnings Ratio = Price per share ÷ Earnings per share
861 Price-Earnings Ratio = HK$4.19 ÷ HK$0.110 = 38.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 861, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since 861’s P/E of 38.2 is higher than its industry peers (13.6), it means that investors are paying more for each dollar of 861’s earnings. This multiple is a median of profitable companies of 22 IT companies in HK including Green Leader Holdings Group, CCID Consulting and EFT Solutions Holdings. You could think of it like this: the market is pricing 861 as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to 861. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Digital China Holdings Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 861 are not fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.